Fed’s inflation fight gets trickier as service costs climb

Persistent US inflation will be hard to stifle after taking root in the service sector of the economy, economists warn, suggesting the Federal Reserve will be forced to press ahead with further interest rate hikes in 2023.

After a year of soaring consumer prices, the inflation rate in the United States is poised to decline rapidly next year. But many economists warn that underlying pressures will keep it at levels well above what the Fed considers acceptable.

“The risk of confusion here is that this is going to sound like massive progress on the one hand and that maybe we’re going to feel like we can relax,” said Jean Boivin, the bank’s former deputy governor. of Canada who now heads the BlackRock Investment Institute. “But those numbers at the end of the year will be a far cry from the postcode of [what] the Fed will be comfortable with it.

The US central bank has aggressively raised interest rates this year in an effort to stamp out high inflation. But its task has become more delicate due to a divergence between the evolution of the prices of goods and services.

Inflation-linked everyday goods such as furniture, used cars and appliances are down. Prices for these items had skyrocketed at the start of the pandemic as demand grew and manufacturing and shipping were halted. Recent data suggests the trend has started to reverse and is likely to continue into 2023 as retailers reduce bloated inventory.

Housing costs are also expected to fall, economists say. Soaring mortgage rates linked to Fed rate hikes drove home prices down. New leases for rental properties are off their recent highs, with asking rents seeing the biggest monthly drop in seven years since real estate firm Zillow started tracking the data.

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Taken together, most Fed officials expect the personal consumption expenditure price index – once volatile food and energy costs are eliminated – to fall at an annual rate of 3 .5% next year. Economists polled by Bloomberg expect core PCE inflation to moderate to around 3% by the fourth quarter of next year.

Both projections remain well above the Fed’s 2% target. In November, the core PCE index rose 4.7% on an annual basis, data showed on Friday, slowing from a peak of 5.4% earlier this year but above the target for the fed.

Falling goods inflation is offset by costs for restaurants, haircuts, travel and other service-sector activities — a dynamic that Fed Chairman Jay Powell has warned of. during his last press conference of 2022.

“Goods inflation has turned up pretty quickly now after not turning up at all for a year and a half,” he said after the Fed’s monetary policy meeting in December, at which the central bank slowed the pace of its interest rate hikes and raised its policy rate. to a new target range of 4.25% to 4.5%. “But services inflation is not expected to come down as quickly, so we’ll have to stick with it. [and] we may have to raise fares to get where we want to go.

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The persistence of services inflation depends mainly on the labor market. Amid labor shortages and strong consumer demand, employers have had to raise wages and benefits to keep pace. Compared to November of last year, wages rose 6.4%, according to data from the Atlanta Fed show.

Fed officials have admitted that its efforts to bring down inflation will lead to job losses, but they maintain that a recession can be avoided. Most officials expect the economy to grow just 0.5% next year and the unemployment rate to rise nearly a full percentage point to 4.6%.

“What they’re trying to do is cool inflation faster than they’re cooling wages,” Diane Swonk, chief economist at KPMG, said of the Fed.

Swonk expects the economy to tip into a recession next year while inflation drops to just under 3% by the end of 2023. The prospect of being blamed for the losses of Jobs puts the Fed “in this horrible position of having to make it look like it’s against the labor market,” she said.

Officials maintain they can get inflation under control by raising the benchmark federal funds rate to between 5% and 5.25% next year and maintaining that level at least until 2024 – a view that is at odds with current market prices suggesting that the central bank will not have to raise its policy rate above 5% and will make about two rate cuts by the end of next year.

Powell also warned that the Fed may need to be even more aggressive if the data does not cooperate, given its unwavering commitment to bringing down inflation. One concern is the potential impact of China’s reversal of its zero-Covid policy, which some economists say could trigger another round of commodity price hikes.

“Without price stability, you have nothing,” said Stephen Cecchetti, an economist at Brandeis University who previously headed the monetary and economics department at the Bank for International Settlements. “You don’t have general economic stability and prosperity. You don’t have financial stability. You just have chaos.

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